Contractor Doctor: How can I stay under the VAT threshold when using subcontractors?

Dear Contractor Doctor

I have a limited company providing IT services that I operate as a sideline to my main job. It turns over around £20,000 each year. I’ve been asked by a client to bid for a project that is worth £148,000, and about £70,000 of that total will be paid out to other IT contractors.

Right now, I am not VAT registered as this might impact on future work. I’d also prefer to avoid setting up another company, with all the costs and administrative tasks associated with it.

How can I stay under the VAT threshold when using subcontractors?

Thanks

Richard

Contractor Doctor says:

According to James Abbott, founder and head of tax at contractor accountant Abbott Moore, contractors have a range of options to consider when presented with a major project that might substantially increase their company’s short-term income.

“The first point to note is that running a limited company with sales of only £20,000 per year is not necessarily the most tax- and cost-efficient way of running a company and is quite unusual,” says Abbott.

“There are several options for a contractor in this situation that may not require the company to register for VAT. They include carefully timing when the project is billed and considering alternative forms of trading.”

Become a sole trader, or register a new company

Abbott confirms that it is possible for an individual to run several businesses in parallel if the projects are sufficiently different: “A contractor running a limited company can also register as a self-employed sole trader or a partnership. These trading vehicles tend to be more cost efficient than running a limited company with low turnover.”

However, contractors must be careful as HMRC has established precedents when dealing with the artificial splitting of businesses and trying to remain below the VAT Registration Threshold, Abbott explains: “There is a well known test case where two publicans tried to avoid registering for VAT by setting up two businesses.

“In the case, the husband handled the ‘wet’ side of the business and sold the beer. The wife had a separate business that sold the food. HMRC decided that the fact that there were two sole trader businesses was irrelevant. The rule now is that this sort of arrangement is treated as a single business for VAT purposes.”

A contractor can register a separate limited company and register it for VAT to manage the new contract, but must be able to demonstrate that is a genuinely a separate commercial business.

Time the VAT transactions

If a contractor genuinely only has a short-term major contract, then it is possible to use the VAT rules to avoid registration, although HMRC must be consulted and be on board with this approach.

“In Richard’s example, if £70,000 was invoiced in month one and £78,000 in month two. The registration threshold has been breached in month two and in theory he should register for VAT by the end of the following month, and start charging VAT within 30 days.”

But HMRC applies several rules to VAT. There are the compulsory registration rules that means a contractor must register if they breach the limit looking back at their turnover over the last 12 month rolling period.

But there is also the ‘look forward test’ catching anyone who expects to turnover more than the VAT Registration Threshold in the next 30 days, which normally means most companies should register, but in Richard’s case may mean he does not have to.

“If HMRC is satisfied that the business won’t be breaching the threshold in the future, and this major project is an anomaly, then the contractor won’t have to register,” says Abbott.

Billing directly and taking a margin

Another alternative is for the contractor to ask the subcontractors to bill the client directly. “There are commercial considerations with asking your subcontractors to do this, warns Abbott. “Chances are the client wants the contractor to provide a solution and wants to pay a single fee to a single supplier.

“Asking subcontractors to bill directly is an option, but could impact negatively on the contractor’s relationship with their client. Each subcontractor would invoice the client directly and the lead contractor could invoice for a cut of the subcontractors’ fees.”